Source: Institutions, Policies, & Cross-Country Differences in Income and Growth
Tags: institutional change, colonial institutions, economic reform, Hong Kong, Singapore, China, Chile, US economic freedom decline, rent-seeking, special-interest politics, shortsightedness, political economy, macroeconomics
Difficulty: Intermediate Prerequisites: Part 1 of these notes (economic freedom, EFW index, PPP). Familiarity with basic growth concepts.
Part 1 established that economic freedom correlates strongly with income and growth. This second set of notes asks the natural follow-up: can countries change their institutions, and what happens when they do? The chapter traces how colonial history shaped institutional paths, identifies three factors that make reform more feasible today, and walks through real case studies (Hong Kong, Singapore, China, Chile) where liberalisation produced dramatic growth. It also examines why the United States saw its EFW rating decline, and why democratic politics can sometimes work against sound economic policy. This is where the chapter moves from measurement to mechanism and real-world application.
History matters for institutions, but countries are not locked into their past. Several nations have reformed their way from poverty to prosperity by increasing economic freedom. However, political incentives (shortsightedness, special-interest politics, rent-seeking) can push policy in the wrong direction, as the decline in the US EFW rating illustrates. The relationship between political decision-making and sound economic institutions remains an active area of research.
Settler colonies vs. extractive colonies
A distinction in the colonial origins of institutions. Colonies where settlers intended to stay (the US, Canada, Australia, New Zealand) tended to develop institutions protecting property rights and limiting government power. Colonies where colonisers focused on resource extraction (much of Africa and Latin America) developed institutions with few limits on government and weak property protections.
In simple terms, settlers who planned to live somewhere built rules they would want to live under. Colonisers who planned to take resources and leave built rules that helped them extract wealth.
Shortsightedness (political)
The tendency of democratic decision-making to favour programmes that deliver immediate, visible benefits while imposing costs that are diffuse and difficult to identify in the future.
Think of it as politicians choosing policies that look good before the next election, even if the long-run costs outweigh the short-run benefits.
Special-interest politics
Political incentives that lead politicians to trade favours to organised interest groups in exchange for political contributions and electoral support.
In simple terms, small, well-organised groups can secure policies that benefit them at the expense of the broader public, because the cost per person in the broader public is too small for anyone to fight over.
Rent-seeking and favouritism
Activities where people or groups divert resources away from productive uses and toward lobbying, campaign contributions, and other forms of political favour-seeking in order to gain advantages at others' expense.
Think of it as spending time and money to get a bigger slice of the existing pie rather than making the pie bigger.
Research confirms that colonial history shaped institutional paths in lasting ways.
Settler colonies (US, Canada, Australia, New Zealand) built institutions that protected individual property rights and limited government power, because the settlers expected to live under those rules themselves.
Extractive colonies (much of Africa, Latin America) were set up to channel resources to the colonising power. These tended to have few constraints on government and weak protections for property and legal fairness.
Even after independence, many formerly extractive colonies have struggled to establish protective institutions. The colonial legacy created a starting point that proved difficult to escape.
While no country can fully escape its past, three developments have widened the window for reform:
The colonial era is over. Former colonies now have sovereignty over their own institutional and policy choices.
The collapse of communism. The end of the Soviet bloc removed a major ideological and practical barrier to market-oriented reform.
Falling transport and communication costs. Globalisation has raised the potential payoff from adopting sound institutions, because countries with good policies can participate more easily in international trade and investment.
Both began liberalising in the 1960s and were among the world's freest economies by the 1970s.
In 1960, both were poor. Their per capita incomes were below those of Brazil, Argentina, and Venezuela.
Decades of sustained growth have transformed them. Their per capita incomes now exceed those of most Latin American countries and many high-income Western European economies.
Both began key reforms in the 1970s. At the time, both were among the least economically free countries in the world.
The reform process increased their EFW ratings substantially.
China became the world's fastest-growing economy during the 1980–2009 period.
Chile grew at an annual rate of 3.1% over the same period and achieved the highest per capita income in Latin America.
Between 2000 and 2009 the US EFW rating fell by nearly a full point.
A one-point decline may sound modest, but research associates it with a 1% decline in the long-term annual growth rate of real GDP.
Factors behind the decline:
Higher government spending
A reduction in the quality of the legal environment
Higher non-tariff trade barriers
A smaller share of credit going to the private sector
More restrictive regulation of business activity
LDCs with low per capita income in 1990 dominate both ends of the growth spectrum: the fastest-growing list and the regressing list.
Low-income countries with sound institutions can grow rapidly for two reasons:
They can copy or emulate technologies and business practices already proven in high-income countries.
The rate of return on investment tends to be higher in capital-scarce economies, attracting inflows of capital.
The prerequisite is sound institutions. Without them, a country cannot benefit from technology transfer or capital inflows.
Many low-income economies continue to stagnate or decline because their institutions stifle trade, entrepreneurship, and investment.
Economics can identify which institutions and policies promote growth, but these institutions are products of the political process.
There is no guarantee that political decision-making will produce sound economic institutions.
Democratic politics introduces three specific problems:
Shortsightedness: bias toward programmes with immediate, visible benefits and hidden future costs.
Special-interest politics: politicians trading favours to interest groups for contributions and electoral support.
Rent-seeking and favouritism: resources diverted from productive activity toward lobbying and political favour-seeking.
The pursuit and maintenance of political power often conflicts with sound economics.
That said, many countries have moved toward better institutions through a variety of political processes. The exact mechanism linking political decision-making to economic reform is not fully understood and remains an active area of research.
The Hong Kong and Singapore case studies are standard textbook examples of how institutional reform can transform a poor economy within a generation. They are frequently cited in development economics and policy debates about what low-income countries should prioritise.
The US EFW decline is a reminder that institutional quality is not a one-way street. Wealthy countries can erode their own foundations through higher spending, weaker legal environments, and increased regulation. The associated growth penalty (roughly 1% per year per point of decline) compounds over time.
"Poor countries are poor because of geography or culture, and institutions cannot be changed." While history and geography matter, the chapter's case studies show that institutional reform is possible and has produced dramatic results within decades. Hong Kong and Singapore went from poorer than Brazil to richer than much of Western Europe.
"Democracy automatically produces good economic institutions." Democratic decision-making introduces shortsightedness, special-interest politics, and rent-seeking, all of which can push policy away from sound economics.
"The US has always been at the top of economic freedom rankings." The US EFW rating declined by nearly a full point between 2000 and 2009, driven by increased spending, weaker legal quality, trade barriers, and regulation.
"If a country reforms, growth is guaranteed." Reforms increase the likelihood of growth, but the political environment can reverse reforms, and sound institutions require ongoing maintenance.
⚠️ Know the difference between settler colonies and extractive colonies and be able to give examples of each.
⚠️ Be ready to name the three factors that have made institutional change more possible (end of colonialism, collapse of communism, lower transport/communication costs).
⚠️ The Hong Kong/Singapore and China/Chile reform stories are commonly tested. Know the approximate time periods and the key outcome (from poor and unfree to prosperous and freer).
⚠️ The US EFW decline, and the specific factors behind it, is a likely exam question. The "1 point drop equals roughly 1% decline in long-term annual GDP growth" figure is testable.
⚠️ Be able to name and define all three political problems: shortsightedness, special-interest politics, and rent-seeking/favouritism.
True or false: Settler colonies tended to develop weaker property rights than extractive colonies. False. Settler colonies developed stronger property rights and limits on government, because the settlers expected to live under those institutions.
Fill in the blank: Between 2000 and 2009, the US EFW rating fell by nearly ___ point(s). One (a full point).
True or false: Democracy guarantees that a country will adopt economically sound institutions. False. Democratic decision-making can lead to shortsightedness, special-interest politics, and rent-seeking that work against sound institutions.
Fill in the blank: Low-income countries with sound institutions can grow rapidly partly because they can ___ technologies and business practices from high-income countries. Copy or emulate.
Q: What is the distinction between settler colonies and extractive colonies, and how did it affect institutional development?
A: Settler colonies were established by colonisers who intended to stay permanently (e.g. the US, Canada, Australia, New Zealand). They tended to build institutions that protected property rights and limited government power. Extractive colonies were set up primarily to extract resources (common in Africa and Latin America). These developed institutions with few limits on government and weak property protections. These institutional differences have persisted well beyond independence.
Q: Name the three factors that have made institutional change more possible in recent decades.
A: The end of the colonial era (former colonies can now make their own institutional choices), the collapse of communism (which removed an ideological barrier to market-oriented reform), and substantial reductions in transportation and communication costs (which increase the payoff from adopting sound institutions by facilitating international trade and investment).
Q: Describe the reform experiences of Hong Kong/Singapore and China/Chile. What was the common pattern?
A: All four began as poor or economically unfree countries that undertook significant liberalisation. Hong Kong and Singapore reformed in the 1960s and were among the world's freest economies by the 1970s; their per capita incomes now exceed those of many wealthy Western European nations. China and Chile began reforms in the 1970s from very low EFW ratings. China became the world's fastest-growing economy (1980–2009), and Chile achieved the highest per capita income in Latin America with 3.1% annual growth. The common pattern: institutional reform preceded sustained, impressive growth.
Q: What are the three problems that democratic political decision-making can introduce, and how do they undermine sound economic institutions?
A: Shortsightedness (favouring programmes with visible short-term benefits and hidden future costs), special-interest politics (politicians trading favours for contributions from organised groups), and rent-seeking/favouritism (diverting resources from productive activity toward lobbying and political favour-seeking). All three channel policy toward outcomes that benefit narrow groups or the short term at the expense of broad-based, long-term economic performance.
Q: What factors contributed to the decline in the US EFW rating between 2000 and 2009?
A: Higher government spending, a reduction in the quality of the legal environment, higher non-tariff trade barriers, a smaller share of credit allocated to the private sector, and more restrictive regulation of business activity. This decline of nearly one full point is associated with a roughly 1% reduction in the long-term annual growth rate of real GDP.
The colonial-institutions material connects to development economics and the work of Daron Acemoglu and James Robinson on inclusive vs. extractive institutions (often covered in comparative economics courses). The discussion of rent-seeking and special-interest politics links back to public choice theory, which appears in microeconomics courses covering government failure. The China and Chile case studies connect to discussions of trade liberalisation and comparative advantage from international trade chapters.
institutional change, colonial institutions, settler colonies, extractive colonies, property rights, Hong Kong economic reform, Singapore growth miracle, China economic reform, Chile economic liberalisation, EFW decline United States, shortsightedness in politics, special-interest politics, rent-seeking, political economy, democracy and economic policy, rich and poor nations, technology transfer, capital inflows, macroeconomics Chapter 17